Intercompany Profit Transactions Bonds Chapter 7 2003 Prentice

Learning Objective 1 Differentiate between intercompany receivables and payables, and assets or liabilities of the consolidated reporting entity. © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 7 -2

Receivable and Payable Accounts Companies frequently hold the debt instruments of affiliates. Direct loans among affiliates produce reciprocal receivable and payable accounts. © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 7 -3

Receivable and Payable Accounts Companies eliminate these reciprocal accounts in preparing consolidated financial statements. © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 7 -4

Learning Objective 2 Defer unrealized profits and later recognize realized profits on bond transfers between parent and subsidiary companies. © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 7 -5

Intercompany Bond Transactions At the time a company issues bonds, its bond liability will reflect the current market rate of interest. © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 7 -6

Intercompany Bond Transactions If the market rate of interest increases… – market value of the liability is less then book value (a realized gain that is not recognized). A decline in the market rate of interest gives rise to a realized loss that is not recognized. © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 7 -7

Constructive Gains and Losses on Intercompany Bonds They are realized from the consolidated viewpoint. They arise when a company purchases the bonds of an affiliate from other entities at a price other than the book value of the bonds. © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 7 -8

Acquisition of Parent Company Bonds Sugar Corporation is an 80%-owned affiliate of Peach Corporation. On January 2, 2006, Peach sells $1, 000 10% , 10 -year bonds at par. On December 31, 2006, Sugar purchases $100, 000 of these outstanding bonds for $104, 500. © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 7 -9

Acquisition of Parent Company Bonds Income from Sugar 4, 500 Investment in Sugar To adjust income from Sugar for the constructive loss on bonds 4, 500 © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 7 - 10

Acquisition of Parent Company Bonds Loss on Constructive Retirement of Bonds 4, 500 10% Bonds Payable 100, 000 Investment in Bonds To enter loss and eliminate reciprocal bond investment and liability amounts 104, 500 © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 7 - 11

Acquisition of Subsidiary Bonds On January 2, 2006, Sugar sold $1, 000 10% , 10 -year bonds at par to the public. On December 31, 2006, Peach purchases $100, 000 of these outstanding bonds for $104, 500. Peach owns 80% of Sugar. © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 7 - 12

Acquisition of Subsidiary Bonds Income from Sugar Investment in Sugar 3, 600 © 2003

Learning Objective 3 Demonstrate how a consolidated reporting entity constructively retires debt. © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 7 - 14

Parent Company Bonds Purchased by a Subsidiary A constructive retirement of parent company bonds occurs when an affiliate purchases the outstanding bonds of the parent. © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 7 - 15

Acquisition of Parent Company Bonds Sue is a 70%-owned subsidiary of Pam, acquired at its $5, 600, 000 book value on December 31, 2003. At the time of acquisition Sue had capital stock of $5, 000 and retained earnings of $3, 000. © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 7 - 16

Acquisition of Parent Company Bonds Pam has $10, 000 par of 10% bonds outstanding with a $100, 000 unamortized premium on January 1, 2005, at which time Sue purchases $1, 000 par of these bonds for $950, 000 from an investment broker. © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 7 - 17

Acquisition of Parent Company Bonds Investment in Pam Bonds 950, 000 Cash 950, 000 To record acquisition of Pam bonds at 95 © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 7 - 18

Acquisition of Parent Company Bonds 10% Bonds Payable 1, 010, 000 Investment in Pam Bonds 950, 000 Gain on Retirement of Bonds 60, 000 © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 7 - 19

Acquisition of Parent Company Bonds A piecemeal recognition occurred during 2005 as Pam amortized premium and Sue amortized $10, 000 discount on bonds that were constructively retired. © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 7 - 20

Acquisition of Parent Company Bonds 10% Bonds Payable 1, 008, 000 Investment in Pam Bonds 960, 000 Gain on Retirement of Bonds 48, 000 © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 7 - 21

Acquisition of Parent Company Bonds Interest Income Interest Expense Gain on Retirement of bonds Interest Payable Interest Receivable 110, 000 98, 000 12, 000 50, 000 © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 7 - 22

Consolidation Working Papers for the Year Ended December 31, 2005 Income Statement Sales Income from Sue Gain on retirement of bonds Interest income Expenses Interest expense Minority interest expense Net income Retained earnings – Pam Retained earnings – Sue Retained earnings 12/31/05 Pam $4, 000 202 (1, 910) (980) $1, 312 4, 900 $6, 212 Adjustments/ Consol. Sue Eliminations idated $2, 000 $6, 000 c 202 a 48 b 12 60 110 b 110 (1, 890) (3, 800) b 98 (882) d 66 (66) $ 220 $1, 312 $4, 900 4, 000 e 4, 000 $4, 220 $6, 212 © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 7 - 23

Consolidation Working Papers for the Year Ended December. Adjustments/ 31, 2005 Consol- Balance Sheet Other assets Interest receivable Investment in Sue Pam Sue Eliminations $39, 880 $19, 100 50 f 50 6, 502 c 202 e 6, 300 Investment (Pam bonds) 960 a 960 $46, 382 $20, 110 Other liabilities $ 9, 590 $10, 890 Interest payable 500 f 50 10% bond payable 10, 080 a 1, 008 Common stock 20, 000 5, 000 e 5, 000 Retained earnings 6, 212 4, 220 Minority interest d 66 e 2, 700 $46, 382 $20, 110 idated $58, 980 $20, 480 450 9, 072 20, 000 6, 212 2, 766 $58, 980 © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 7 - 24

Subsidiary Bonds Purchased by Parent On December 31, 2003, Sky had $10, 000 par of 10% bonds outstanding with an unamortized discount of $300, 000. The bonds pay interest on January 1 and July 1. They mature in five years on January 1, 2009. © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 7 - 25

Subsidiary Bonds Purchased by Parent On January 2, 2004, Pro Corporation purchases 50% of Sky’s outstanding bonds for $5, 150, 000. This transaction results in a loss of $300, 000 from the viewpoint of the consolidated entity. The entity retires a liability of $4, 850, 000 at a cost of $5, 150, 000. © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 7 - 26

Subsidiary Bonds Purchased by Parent During 2004, Sky records interest expense on the bonds of $1, 060, 000 of which $530, 000 relates to the intercompany bonds. Pro records interest income from its investment in bonds during 2004 of $470, 000. At December 31, 2004, their books do not show the $240, 000 of the constructive loss. © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 7 - 27

Subsidiary Bonds Purchased by Parent 90% of Sky’s $750, 000 reported income $675, 000 Deduct: $300, 000 constructive loss × 90% – 270, 000 Add: $60, 000 recognition of 54, 000 constructive loss × 90% Investment income from Sky $459, 000 © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 7 - 28

Subsidiary Bonds Purchased by Parent Investment in Sky 675, 000 Income from Sky 675, 000 To record 90% of Sky’s reported income for 2004 © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 7 - 29

Subsidiary Bonds Purchased by Parent Income from Sky 270, 000 Investment in Sky 270, 000 To adjust investment income from Sky for 90% of the loss on the retirement of Sky’s bonds Investment in Sky 54, 000 Income from Sky 54, 000 To adjust investment income from Sky for 90% of the $60, 000 piecemeal recognition of the constructive loss on Sky bonds during 2004 © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 7 - 30

Subsidiary Bonds Purchased by Parent Investment in Sky 01/01/04 ($11, 259, 000 × 90%) Add: Income from Sky Investment in Sky 12/31/04 $10, 125, 000 459, 000 $10, 584, 000 © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 7 - 31

Learning Objective 4 Adjust calculations of minority interest amounts in the presence of intercompany profits on debt transfers. © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 7 - 32

Minority Interest Minority interest expense for 2004 is $51, 000, which is assigned to the constructive loss to Sky. The constructive loss reduces consolidated net income for 2004 by $216, 000 which is reflected in the consolidated income statement. © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 7 - 33

Minority Interest Decreased by: Constructive loss Elimination of interest income Total decreases Increased by: Elimination of interest expense Reduction of minority interest expense Total increases Effect on consolidated net income for 2004 $300, 000 470, 000 $770, 000 $530, 000 24, 000 $554, 000 $216, 000 © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 7 - 34

Minority Interest Loss on Retirement of Bonds Interest Income 10% Bonds Payable Investment in Sky Bonds Interest Expense 300, 000 470, 000 5, 240, 000 530, 000 © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 7 - 35

Consolidation Working Papers for the Year Ended December 31, 2004 Income Statement Sales Income from Sky Interest income Expenses Interest expense Loss on bond retirement Pro Sky Adjustments/ Consol. Eliminations idated $25, 750 $14, 250 459 c 459 470 b 470 (21, 679) (12, 440) (1, 060) b 530 a 240 b 60 Minority interest expense c 51 Net income $ 5, 000 $ 750 Retained earnings – Pro 13, 000 Retained earnings – Sky 1, 250 e 1, 250 Retained earnings 12/31/04 $18, 000 $2, 000 $40, 000 (34, 119) (530) (300) (51) $ 5, 000 $13, 000 $18, 000 © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 7 - 36

Consolidation Working Papers for the Year Ended December 31, 2004 Balance Sheet Pro Other assets Interest receivable Investment in Sky $34, 046 250 10, 584 Investment in Sky bonds 5, 120 $50, 000 $12, 000 Other liabilities Interest payable 10% bonds payable Capital stock Retained earnings Minority interest 20, 000 18, 000 $50, 000 Sky Adjustments/ Eliminations $25, 000 $ 2, 740 500 9, 760 10, 000 2, 000 $25, 000 e 250 c 459 d 10, 125 a 5, 120 e 250 a 4, 880 e 10, 000 c 51 d 1, 125 Consolidated $59, 046 $14, 740 250 4, 880 20, 000 18, 000 1, 176 $59, 046 © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 7 - 37

Minority Interest Investment in Sky Minority Interest Income 10% Bonds Payable Investment in Sky Bonds Interest Expense 216, 000 24, 000 470, 000 5, 180, 000 530, 000 © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 7 - 38

Minority Interest Increased by: Elimination of interest expense Decreased by: Elimination of interest income Increase in minority interest expense ($60, 000 piecemeal recognition × 10%) Total decreases Annual effect on consolidated net income $530, 000 $470, 000 6, 000 $476, 000 $ 54, 000 © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 7 - 39

Summary of Intercompany Bond Account Balances on Separate Books December 31, Pro’s Books (000) Investment in Sky bonds Interest income Interest receivable 2005 2006 2007 2008 $5, 090 $5, 060 $5, 030 $ 5, 000 470 470 250 250 Sky’s Books (000) 10% bonds payable Interest expense Interest payable $9, 820 $9, 880 $9, 940 $10, 000 1, 060 500 500 © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 7 - 40

Summary of Consolidation Working Paper Adjustments December 31, Debits Investment in Sky (90%) Minority interest (10%) Interest income 10% bonds payable Interest payable 2005 2006 2007 2008 $ 216 $ 162 $ 108 $ 54 24 18 12 6 470 470 4, 910 4, 940 4, 970 5, 000 250 250 Credits Investment in Sky bonds Interest expense Interest receivable $5, 090 $5, 060 $5, 030 $5, 000 530 530 250 250 © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 7 - 41